Role of the Central Bank

A key issue in any institutional structure of regulatory and supervisory agencies is the posi­tion and role of the central bank. In the vast majority of countries, the central bank has historically been responsible for both the systemic stability and the prudential regulation and supervision of banks. In only a very small minority of cases has it also been respon­sible for the supervision of non-bank financial institutions. Even so, there are several alternative models for the role of the central bank, depending on whether it is involved in monitoring the payments system, providing emergency liquidity to the markets, super­vising banks, managing deposit insurance, or playing a role in providing the safety net or crisis resolution.

Nevertheless, almost universally, the central bank is allocated at least some role in maintaining systemic stability, even if it is not involved in the prudential supervision of the banks that make up the system. However, its role raises a number of issues.

The first issue is that of power. If the central bank has independent powers to set interest rates, the combination of a widespread regulatory function with monetary control might appear to place excessive powers within the hands of unelected officials. It might create the public perception that any “safety net” that might apply to banks will also be extended to a wide range of financial institutions.

Another issue is that of possible conflicts of interest. These conflicts could arise, for example, because of monetary policy implications of bank resolution actions, thereby pos­ing a tradeoff among conflicting objectives. This concern is frequently advanced by aca­demic economists as the main argument against allowing the central bank to participate in regulation. Those economists believe that a central bank with responsibility for pre­venting systemic risk is more likely to loosen monetary policy on occasions of difficulty.5

The question of conflicts of interest might be an argument in favor of giving the central bank regulatory responsibilities. There are several questions: If not the central bank, then which other body should have such powers? What conflicts of interest might the body have? If the central bank does not play this role, will it then be given to a body more subject to direct political influence? If public policy conflicts do arise, they will do so regardless of whether supervision is a responsibility of the central bank. Such conflicts may arise no matter what institutional structure is created, and the conflicts must be resolved somehow. The key issue is whether the transaction costs of resolving them are higher or lower when they are resolved internally rather than externally. The advantages of having the central bank also serve as the supervisory agency of banks in the financial system may be summarized as follows:

Because the central bank has responsibility for oversight of the system as a whole and for stability of the payments system, there are powerful synergies in being the supervisory agency for the institutions that make up the system. Some analysts doubt that, in practice and when stability is under strain, it is feasible for an agency to be responsible for the system but not for the individual firms.

The central bank necessarily gains information about banks by virtue of its monetary policy operations. There are, therefore, information synergies between the conduct of monetary policy and the prudential supervision of banks. The central bank needs infor­mation about the solvency and liquidity of banks when considering its role as lender of last resort.

The central bank often has an independent status in the economy that might not be replicated by other regulatory or supervisory agencies. Moreover, the central bank usually has considerable authority in an economy, and that authority enhances the credibility of regulation and supervision—if it is allocated this task.

From time to time, conflicts of interest can arise between the requirements of mon­etary policy and the prudential position of banks. It can be argued that such conflicts are better resolved internally within a single agency than externally between different agencies. Monetary policy operates largely through interest rates that also affect the financial position of banks. In addition, economies of scale may be derived from combin­ing responsibility for monetary policy and prudential supervision of banks. Moreover, thestatus of the central bank may enhance its ability to recruit the necessary skills for bank supervision.

There are, however, arguments against having the central bank as the supervisory agency of banks. Such an arrangement may be viewed as concentrating excessive power in the hands of an unelected central bank whose accountability may be weak. Regulatory failures may compromise the authority of the central bank in other areas of its activity. For example, the central bank’s objective of ensuring monetary stability may conflict with its objective of securing the safety and soundness of banks.

In a recent reform of institutional arrangements for financial regulation and super­vision, the government of Ireland embedded prudential regulation of banks and other financial institutions within the central bank (which was already responsible for banks and securities) but at the same time changed the structure of the bank. Supervision and monetary stability are now separated and run as independent arms within the central bank. However, because Ireland is a member of the European Monetary Union, the mon­etary policy powers of the central bank are very limited. Similarly, as discussed earlier, the Netherlands Bank now combines prudential supervision of all sectors with its macro­prudential surveillance responsibilities.

In practice, no bank regulator could, or should, ever be totally independent of the cen­tral bank. The central bank is the monopoly provider of the reserve base and the lender of last resort. Any serious banking problems are bound to lead to calls for the central bank to use its reserve-creating powers. Moreover, the central bank, in its macro-policy opera­tional role, must have a direct concern with the payments and settlements system, the money markets, and the development of monetary aggregates. Any serious problem with the health of the banking system will touch on one or more of these concerns. Therefore, there are bound to be, and must be, very close relationships between the bank regulator and the monetary policy authority. Establishing such relationships is one of the priorities in structural reform.

Furthermore, with the growing international integration of financial institutions and markets, central banks are increasingly focused on macroprudential surveillance as part of their systemic stability responsibilities (which is reflected in the publication of financial stability reports by increasing numbers of countries). This top-down approach to analyz­ing financial soundness requires very close collaboration with supervisory bodies—within or outside the central bank (e. g., in data sharing, conducting aggregate stress tests, or providing transparency of aggregate information).

This need for coordination might suggest unifying the functions within the central bank. However, for a variety of reasons (including the need for confidentiality), when the central bank combines both roles, the supervisory department is usually separate from the monetary policy department. Coordination is regarded as necessary only between the top officials. Such regular meetings of senior officials can be organized just as easily whether their subordinates are in separate buildings or the same building and whether their orga­nization is formally separate or not. Perhaps the only real difference is that disagreements between senior officials would be settled (quietly) within the central bank in the case of unification, and they would be settled outside the bank, presumably by the minister of finance, with more likelihood of publicity, in the case of separation. However, it is hard

to identify actual cases of publicly observed disagreement between the central bank and the bank regulator in countries where there is such a separation.

The bottom line is that banking realities will force considerable coordination and interaction between the senior officials dealing with monetary policy and with bank supervision. There must always be a close link between the central bank and the supervi­sory authority. The question of whether the banking supervisory body is formally within or outside the central bank is then essentially a subsidiary issue, depending on perceptions of the appropriate locus of power and responsibility. Those perceptions will vary depend­ing on the accidents of history and culture. There is no single, best approach under all circumstances, as is clearly evidenced by the variety of regulatory structures in different countries.

Whatever institutional structure is created, there will always be an important need for effective coordination among the central bank, the regulatory agency (or agencies), and the ministry of finance. In particular, cooperation, coordination (especially when inter­vention is made), and (perhaps above all else) information sharing are needed around the world. Mechanisms are needed to ensure information sharing regardless of the type of institutional structure created for regulation and supervision.

The overall conclusion is that safeguarding financial stability is a core function of the modern central bank, even though it may not be responsible for regulating and supervis­ing banks and other financial institutions. Irrespective of the decision about the role in regulation and the supervision of individual financial institutions, the central bank must necessarily be centrally involved in the safety net arrangements, the liquidity support, the payments system, and the maintenance of stability in the financial system as a whole. In cases where the central bank is not responsible for regulation and supervision, its respon­sibility for financial stability requires cooperation with and from those agencies that are responsible for regulation and supervision. This issue cannot be avoided, and explicit arrangements are needed.

International experience indicates a wide variety of institutional regulatory formats, sug­gesting that there is no universal ideal model. A key consideration is the extent to which regulatory structure affects the overall effectiveness and efficiency of regulation and super­vision, because this consideration should be the ultimate one when choosing between alternative formats. This consideration is also the reason why the issue of institutional structure is important.

However, in itself, institutional structure does not guarantee effective regulation and supervision, and it would be wrong to assume that changing the structure of regulatory institutions is a panacea. What an institutional structure does is it establishes the frame­work in which to optimize a regulatory regime. In effect, institutional structure provides the architecture of regulation and supervision. More appropriate structures may help, but, fundamentally, better regulation comes from stronger laws, better-trained staff members, and better enforcement.

If effectiveness of supervision, as judged by the observance of various international standards and codes, is seen to be adversely affected, owing to weakness in specific areas (core principles), then the key issue for an assessor is the extent to which changes in the institutional structure could help overcome those weaknesses. If the lack of compliance with some of the core principles reflects either weak infrastructure or weak supervisory capacity of sectoral supervisors, then forming a unified supervisor may not be the answer. There is also additional risk that the existing weaknesses could be exacerbated by attempt­ing to form a unified supervisory structure without addressing up front the problems at the sectoral level of supervisors. Moreover, when a change in institutional structure has been implemented, it is important to assess whether this change has adversely affected the quality of enforcement in a particular sector (e. g., because of a loss of skilled staff members in securities laws enforcement) or has weakened regulatory governance (e. g., because of weakened transparency or independence). The ultimate decision is fundamentally driven by the extent to which the financial services industry has integrated its functions and adopted centralized risk management.

With the emergence of mixed financial institutions, the case for unified agencies has strengthened as they more closely mirror the emerging structure of financial systems and the business of financial firms. Whatever decisions are made, it is important to recognize that a perfect institutional structure is a chimera, and it might be necessary to accept the inevitability of working within an imperfect structure.